Analysis: Investors face U.S. default risk with no Plan B

Traders work on the floor of the New York Stock Exchange in New York July 25, 2011.

LONDON, Jul (Reuters) - Not for the first time, asset managers may be playing a high-risk game as they face the threat of a U.S. debt default without concrete contingency plans.

It highlights the investment community's reluctance actively to seek insurance for a low probability or "tail risk" event, even after suffering huge losses following the collapse of Lehman Brothers in 2008. This was the tail risk that materialized.

At the same time, those investors who have hedged may end up suffering bigger losses in the event that U.S. lawmakers do reach a deal because the risk of default is political, not a case of real solvency.

The clock is ticking toward an August 2 deadline to avoid a default, with politicians deeply divided over a broad deficit reduction deal that would clear the way for Congress to raise the $14.3 trillion debt ceiling.

The risk of a U.S. default -- that would, to say the least, trigger a sell-off among pension and money market funds which must hold triple-A assets and push up long-term rates -- is getting bigger day by day. Yet mainstream investors appear to be insufficiently prepared for the worst.

Illustrating their relaxed stance, fund managers polled by Bank of America this month did not even list the U.S. default risk as one of their top 5 biggest tail risks. The yield on one-year U.S. Treasuries stands at just 0.17 percent, near all-time lows, supporting the view that investors are not panicking.

"The main scenario of most investors is they will reach an agreement, I don't think investors are prepared. It's hard to prepare for such a tail risk," said Alessandro Bee, fixed income strategist at Sarasin.

"It's like preparing for a nuclear fallout. Risk cannot be insured. Normal risk can be insured but insuring this sort of tail risk is something that is not possible."

According to Sarasin, households, pension funds and money market funds held a combined $1.8 trillion of U.S. government bonds, out of $9.6 trillion outstanding.

The bigger holders are foreign central banks -- mainly China and Japan -- which hold a total of $3.3 trillion. Here, the decision is a political one.

Xia Bin, academic adviser to the People's Bank of China, said China should not worry about stalled U.S. debt talks, predicting that politicians will ultimately reach a deal.

Japanese Finance Minister Yoshihiko Noda, when asked about the breakdown in the U.S. debt talks, only said that he would be watching the situation.

Given the lack of alternatives and the depth of the market, investors have been sticking to U.S. Treasuries for the time being. Triple-A euro zone government bonds, by contrast, have debt outstanding of just $4.3 trillion.

DEFAULT REPERCUSSIONS

A default would knock triple-A U.S. ratings down to at least selective default category overnight.

Conventionally, those who must hold triple-A securities for regulatory reasons are likely to be forced to sell in that event, although it's not clear cut.

If all U.S. government debt were to be rated in the default category, that would trigger downgrades on debt issued by related state entities and others who are benchmarked against government debt. This leaves no investable triple-A securities in the United States.

"The perceived wisdom is that they would have to sell, although there may be room for maneuver for this sort of default. It's not outright default," said Phyllis Reed, head of fixed income research at private asset manager Kleinwort Benson.

"The probability is less than one percent. If all of investors decided to position for this low probability event, and if nothing happens, they are going to lose a lot of money."

The International Swaps & Derivatives Association said it is not clear whether credit default swaps referencing the United States would trigger if a debt deal was not reached by Aug 2.

The cost of insuring the United States against default stands at just 56 basis points, nearly half the March 2009 peak. The CDS curve is nearly flat -- this in itself shows investor jitters, but not the sort of pricing in the market that expects an imminent default.

"Our view is the U.S. will go into some kind of technical default but they are unlikely to go into technical default on government traded debt obligations. They are more likely to default on other government payments such as defense contractors or social security obligations," said Percival Stanion, head of multi-asset strategy at Baring Asset Management.

"The delay of payments to other parts will slow the U.S. economy and cause the Federal Reserve to move quantitative easing back on the agenda. So perversely we could see a rally on U.S. government bonds even when there is talk of default."

(Additional reporting by Sujata Rao)